The Last Crisis May Set the Stage For the Next One
WASHINGTON - A central economic question of our time is whether the policies undertaken to recover from the last financial crisis are laying the groundwork for the next. We now have two reports from reputable groups suggesting just that.
The first comes from the Bank for International Settlements, which was created in 1930 to handle reparations payments from World War I - reparations that were soon canceled. The BIS is now a major source of economic research and statistics. Recently, it has acted as the loyal opposition to the easy-money policies adopted in the United States, Europe, Japan and elsewhere. Its just-released annual report continues its dissent.
The BIS critique goes like this. Low interest rates have sustained the recovery, but the support is fragile. The economy relies too much on debt, which cannot build forever, and artificially high asset prices (stocks, homes, bonds) may someday tumble from unrealistic levels. A new crisis could be severe because governments have already deployed their standard anti-recession tools: cheap credit and big deficits.
The BIS' most intriguing point is that a new recession or financial crisis might originate with "emerging-market" countries: China, Brazil, India, Turkey and the like. Although there has been debt repayment in the United States, the opposite has happened in some emerging-market countries, says the BIS. Private firms have assumed dollar loans worth $3 trillion, even though their "debt-servicing capacity has deteriorated." Will defaults follow?
Overvalued stocks pose another threat. China is a case in point. Its Shanghai stock index advanced an eye-popping 125 percent from mid-2014 to late May 2015 - a leap widely attributed to speculation (and now being partially reversed). Emerging-market countries constitute about half the world economy, up from a third in the late 1990s, so any setbacks could spread to advanced countries. Weaker exports would be one channel; losses to internationally diversified investors would be another.
The second warning comes from the Organization for Economic Cooperation and Development (OECD), a group of 34 mostly wealthy nations. In a new study, it cautions that "low interest rates threaten [the] solvency of pension funds and insurers." The problem is that today's unanticipated low interest rates may not be high enough to pay the benefits promised to retirees.
Not all pensions or life insurance policies are vulnerable. The main threats involve "defined-benefit" pensions and life insurance annuities. Still, these are huge. In 2013, U.S. insurance companies had $3.3 trillion in reserves to back annuities, according to the American Council of Life Insurers. Defined-benefit pensions had $2.7 trillion of reserves in 2013, reports Pensions & Investments magazine.
By pledging to pay fixed amounts, defined-benefit plans and annuities offer security. Unfortunately, the guarantees were given when interest rates were higher and hardly anyone imagined them going as low as they have - and staying low. Some plans and insurers might miss their guarantees. Worse, says the OECD, some might try to boost returns by shifting to riskier investments. Bad bets could lead to insolvency. Similar dangers afflict pensions and annuities in other advanced countries.
Most financial crises are surprises. If they had been anticipated, chances are they could have been prevented. The fact that these dangers are now being discussed suggests that, though they may pose problems, they won't trigger a panic akin to the Lehman Brothers collapse in 2008. (The same logic, incidentally, applies to a possible Greek debt default. It's been so long discussed and analyzed that the side effects outside Greece are likely to be limited.)
"Interest rates have never been so low for so long," says the BIS report. "Yet exceptional as this situation may be, many expect it to continue. There is something deeply troubling when the unthinkable threatens to become routine."
The trouble with this analysis is not that it's wrong but that it begs the practical question: What's the alternative to low interest rates? It's hard to argue (and the BIS doesn't) that the weak global recovery would have been stronger if interest rates had been higher.
But it's also true that persistently low rates may become destabilizing. Global capital is mobile. Investors with hundreds of billions of dollars scour the world to find slight differences in returns. These massive inflows and outflows of funds can spawn booms and busts. If the Federal Reserve raises interest rates, will spillover effects hurt other economies?
"There is great uncertainty about how the economy works," the BIS says. This is more than a throwaway line. Ignorance subverts confidence, and doubt hampers a vigorous recovery.
